Tax-advantaged life insurance plans offer smart way to fund benefits.

Bank chief executives and chief financial officers who still think of employee benefit programs as strictly a human resources issue are ignoring what can be an opportunity to use an otherwise unavailable tax-preferred financing strategy.

Employee benefit funding has been under scrutiny of late as a result of the implementation of the Financial Accounting Standards Board's Statement 106, and the health care and welfare reform proposals that have come out of Washington - both of which add significantly to corporate expense and threaten the bottom line.

FAS 106 requires current accounting for the expected cost of postretirement benefits other than pensions. Banks frequently provide health care benefits to retirees; now these liabilities must be accrued for and fully established by the time the individual employee retires. This new standard, which most banks have been dealing with for more than a year, can increase expenses by millions of dollars annually.

Health Care Reform

Then there's the Clinton administration's health care reform proposal, which will up the ante on health and welfare care costs for active employees.

So what's the solution? Can a financial institution meet its benefit liability obligations and remain profitable at the same time?

The answer is a qualified yes, as long as bank financial officers realize that what was once the private domain of human resources now necessitates a more balance-sheet-oriented perspective.

While human resource vice presidents should still be heavily involved in any decisions concerning employee benefits, the financial and accounting concerns raised by these new regulations requires direct involvement of the chief financial officer.

Once that mindset has been successfully changed, the problem of how to meet these new liability expenses can be addressed. And then, only three viable options exist.

Unsatisfactory Choices

The first option is to take a one-time hit on the balance sheet; a writeoff of this nature would pose a significant threat to profitability and capital levels, and also cause concern among shareholders. For this reason, few banks have chosen to go this route.

The second option is to earn your way out of the problem by investing in high-yield investments. Unfortunately, interest rates are down and banks are hard pressed to find safe investment vehicles that provide the hefty returns they need.

For example, real estate lending, which was once a primary source of revenue for many banks, is now pursued only with extreme caution. And other high-yield asset categories, such as highly leveraged transactions, have also fallen into disfavor.

The third option is to find an alternative source of funding for the benefit costs, such as bankowned life insurance (BOLI) programs.

$1 Billion in Purchases

Over the past year, many of the country's largest financial institutions, including Bane One, Wachovia, and Comerica, have made cumulative BOLl purchases totaling more than $1 billion as a means of generating the cash flow needed to fund new benefit liabilities.

While there is no direct funding of postretirement liabilities with life insurance, a BOLl program creates significant assets and P&L gains that closely match the emerging liabilities

BOLI isn't a new concept. In fact, it's been around for nearly a decade. But its merits have recently come back into favor as a direct result of the strain being placed on banks to meet ever-increasing benefit obligations while also bowing to the pressure of regulartory guidelines, which limit the ways banks can invest.

Low Risk, High Return

The program's attraction is easy to understand. It's a highly stable, low-risk investment that offers annual after-tax returns two to three percentage points higher than traditional bank investments. It is also appreciated by employees, who view BOLI as a smart way for their employer to finance their benefit programs.

In a BOLl program, a bank purchases life insurance policies on the lives of its employees. The bank pays .the premiums, owns the cash value, and is designated beneficiary.

BOLI can be structured in a number of ways, but an increasingly popular approach a single premium program. In some respects, it is similar to the investments banks made in municipal bonds before limitations were instituted - the policies earn long-term interest rates, and the interest accumulation is not taxable.

Permitted by Comptroller

Despite the major BOLI investments made by more than a dozen major financial institutions in the past year, many bank directors and CFOs are under the impression that the purchase of life insurance is strictly forbidden by the Comptroller's office, when in fact it is not.

The Comptroller's guidelines surrounding a bank's purchase of life insurance are very clear: A bank can purchase BOLI to finance employee benefit expenses. However, the assets need not be segregated and contractually tied to such purposes. Essentially the assets provide a P&L offset to the costs or accruals for such benefits. When insurance proceeds are realized, the cash can be used to help finance benefit costs.

So the first step in establishing a BOLl program is to calculate the cost of benefit plan expenses. The calculation takes into account the current and future costs the bank will incur for each employee through their expected retirement. The cost is then discounted to current-year dollars. A bank can purchase: enough BOLI to generate present-value gains up to the level of the discounted benefits costs.

Highly Rated Insurers

Using BOLl, banks can realize after-tax-returns on assets-that are roughly double the levels earned on other assets. The high after-tax equivalent returns stem in part from the fact that the cash value accumulation inside an insurance contract is not taxed if the policies are held until the death of the insured.

It's important to note that this high ROA is earned while investing only with high-quality insurance carriers; BOLI programs are structured with products provided by some of the most highly rated - AA or AAA - insurance companies in the country.

Because BOLI is used to fund long-term employee benefits and because of adverse tax consequences that may apply if funds are withdrawn from the insurance policies before the death of the insured, an investment in BOLI should be viewed as a long-term asset with limited liquidity. On the positive side, the tax benefits of BOLI are akin to holding a perpetual municipal bond.

But the window of opportunity is rapidly closing. With the average BOLI investment landing somewhere in the range of $50 million, the capacity of the insurance industry to absorb the business is limited.

Those who act quickly to invest in BOLI will see the results in the lower right-hand corner of their balance sheets at the end of the year. And so will those who don't.

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